JAForlines Global: Stating the Obvious?

04/18/2013

New York, April 16th, 2013, Advisor Update® If you’ve watched the financial news lately, you know that US stocks are at all-time highs. But is that really true? Yes, the S&P 500 eclipsed its all-time high set in October 2007, but this fails to take inflation into account. The nominal value of a basket of stocks isn’t what matters; what matters is what it can buy. Adjusted for CPI, the S&P 500 is substantially below its all-time high, which in real terms was set in March 2000. Over the long run, inflation-adjusted stock market returns tend to follow the trend of real GDP growth. In the US this has been about 3% annually. Over shorter periods, stocks are affected by an infinite number of factors, such as fiscal, regulatory and monetary policy, investor sentiment, etc. So what is driving this current divergence from the 3% per annum real stock market returns? In our view, monetary policy is the biggest driver.

Investors remember the 90s fondly. Everything rose in value—stocks, bonds, commodities, and the dollar. But in the end, all we were left with was a stock market bubble. In hindsight, we know that these fond memories of the 90s are foolish because ultimately the rise in asset prices only served to misallocate capital. And yet, following the bursting of the tech bubble in 2000, the Fed pursued an even greater credit expansion. This ended in an even greater misallocation of capital in the housing bubble. Today, the Fed has adopted the mantra of “the third time’s the charm,” as Bernanke merrily embarks on the greatest central bank balance sheet expansion in history. But that doesn’t mean that stocks are in bubble territory yet. By most traditional measures, stocks are reasonably priced. And with global central banks continuing to flood the financial system with liquidity, there is no reason to think that the music is going to stop just yet.

Another force underpinning stock prices are corporate profits, which in the US are at all-time highs, adjusted for inflation. While the Fed has been somewhat unsuccessful in generating strong economic growth, its low interest rate policy has been enormously beneficial for corporate profits. Rather than using the low interest rate regime to make long-term capital investments, which would drive a strong economic recovery, companies have found it to be more beneficial on a risk/return basis to refinance their debt to drive down interest costs.

Additionally, persistently high unemployment has been used to drive down real unit labor costs, further buffeting profits. On a net basis, this is clearly not positive for the US economy, but it is an unavoidable consequence of the current economic environment, and one would be foolish not to take advantage of it.

Lastly, the global financial crisis drove many industries to consolidate significantly. The most obvious example is in the banking sector, where there are now only four major commercial banks, but similar forces have driven consolidation across most industries. This consolidation has led to decreased competition resulting in wider profit margins and higher profits. Again, on a net basis this is not positive for the US economy, but it has supported stock prices.